Risky Adjustable-Rate Mortgages Are Starting to Make a Big Comeback

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Dan Caplinger is an attorney and financial planner covering retirement, ETFs, personal finance, and general investing for the Motley Fool. With nearly 20 years of diverse experience as a tax and estate planning lawyer, trust administrator, personal financial advisor, and independent consultant, Dan has developed a healthy skepticism of the mainstream financial industry and aims to make complex legal and financial concepts easier for his readers to understand. Dan has worked with the Motley Fool since 2006 as a retirement, tax, and investing expert with a focus on introducing new investors to the opportunities of smart financial planning.

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The dramatic rise in interest rates that has occurred over the past two months has had a big impact on the mortgage-loan market. Rates on standard 30-year mortgages have gone from below 3.5 percent as recently as late April to well above 4.5 percent currently, according to Bankrate, significantly increasing the monthly payments that new homebuyers will pay and making it harder to qualify for mortgage loans.

But there's one type of mortgage loan that hasn't seen interest rates budge: adjustable-rate mortgages. They're risky, and some blame them for the last housing bubble, but you can expect to see a big rise in the use of ARMs -- at what could be the worst possible time.

The Risks and Rewards of Adjustable-Rate Mortgages

Until recently, it didn't make sense for most would-be borrowers to look seriously at ARMs. With fixed-rate mortgages available at interest rates near or in some cases below those offered for ARMs, there was no substantial reward to make up for taking on the risk of frequent changes in the interest rate you'd pay on your loan.

Now, though, ARMs are the only way you can get a mortgage with a rate below 3 percent, and that's almost certain to make homebuyers who've missed out on low fixed-rate mortgages take a second look at adjustable-rate mortgages. Indeed, even as other mortgage rates have soared, ARM rates as reported by Bankrate have held steady between 2.7 percent and 3.1 percent. As Freddie Mac Vice President and Chief Economist Frank Nothaft observed recently, "with the ongoing run up in fixed mortgage rates, adjustable-rate mortgages are becoming more popular among homeowners looking to refinance and for home purchasers." Last week, the Mortgage Bankers Association said that the share of adjustable-rate mortgage activity rose to its highest level since July 2008.

The benefits of an adjustable-rate mortgage when fixed rates are relatively high are easy to see. With payments that are amortized over the same period as a 30-year fixed mortgage, monthly payments on ARMs can be much lower when there's a big gap in rates between fixed and adjustable mortgages. For instance, at 3 percent, your monthly payment on a $200,000 home would be $843. At 4 percent, the payment would be $955. Put another way, if your income only qualified you for a monthly payment of $843, then paying a higher rate would only allow you to take out a loan for $177,000. So having access to lower-rate ARMs will let you spend more on the house you want, which is useful especially in light of the increases in home prices over the past year.

The problem with ARMs, though, is that the interest rate is subject to change throughout the life of the loan. For the lowest-rate ARMs available, that initial low rate is locked in for only one year, with subsequent resets on an annual basis. If short-term interest rates start to follow longer-term rates higher, then your monthly payment will skyrocket. Other types of ARMs allow you to lock in the initial rate for a longer period of time, but they start with higher interest rates, too.

Be Careful With ARMs

Before you consider an adjustable-rate mortgage, you need to understand exactly what its terms mean and what effect they could have on your payments in the future. Look closely at provisions governing maximum rate increases both annually and over the life of your loan, and run the numbers to see how much your monthly payment would rise under a broad set of realistic scenarios. The short-term interest rates on which ARMs are based are still near record lows despite the run-up in other mortgage rates, but economists believe that eventually, those short-term rates will follow suit. If you don't want to make the same mistake that resulted in many borrowers losing their homes to foreclosure during the housing bust, then taking out an adjustable-rate mortgage without having the capacity to make payments in a more normal interest rate environment is a bad idea.

The Treasury Department has been withholding as much as 15% of Social Security benefits from a rapidly growing number of retirees who have fallen behind on federal student loans -- five times as many as in 2001. Even something as simple as credit card debt can hurt you in retirement, says John Ulzheimer, president of SmartCredit.com.

"When it comes to credit card debt, you absolutely have to get out of it before you hang up your company badge," Ulzheimer says. "It's very likely the most expensive debt you're carrying at 13 percent to 15 percent interest on average, and twice that in some cases. No retirement nest egg can guarantee that kind of growth."

Leaving the workforce might help you cut costs in some areas -- for example, your pricey commute to the office -- but you can never underestimate the cost of aging.

"Many studies show that some retirees even spend more in retirement than they did when they were working," says Susan Garland, editor of Kiplinger's Retirement Report.

"In the early years, you may be embarking on long-delayed travel and hobbies. And as the years go by, your health care costs are sure to rise. House-related maintenance costs, insurance and property taxes are sure to be on the upswing as well."

"More and more Americans say they plan to pay for retirement by working longer, but in reality, many retirees end up quitting sooner than planned," says Greg Burrows, senior vice president for retirement and investor services at The Principal.

One third of American workers said they plan on working past age 65 in a recent survey by the Employee Benefit Research Institute, but more than 70 percent of retirees said they actually quit before that milestone.

Then there's the job market to consider, which doesn't take kindly to workers who are past their prime. In 2011, the median length of unemployment for people 55 and older was 35 weeks, up from 10 weeks before the recession, according to the Government Accountability Office.

Medicare is an excellent resource for retirees needing health care support, but here's a wake up call: It doesn't cover all long-term care.

Medicare coverage excludes extended nursing home stays, custodial care, or an in-home nurse to help out if you're unable to dress, feed or bathe yourself.

"Medicare pays for limited nursing-home and home-health care for short periods to provide continuing care after a hospital stay," Garland says. "For example, skilled care in a facility is limited to 100 days. It may be wise to consider long-term care insurance to cover those costs."

Never underestimate the crippling power inflation has over your retirement savings.

"Too many people have the illusion that money is safe as long as the balance doesn't go down, but the reality is that inflation will eat into your purchasing power unless you learn how to properly manage and invest your wealth," writes David Ning of MoneyNing.com.

"Those who put all their money in a savings account may not experience the volatility that comes with different investments, but they are sure to be able to afford less and less as years go by, which is a real threat too."

Contrary to popular belief, investing savvy isn't something only the rich are born with.

But if you want to invest wisely, do yourself a favor and leave the stock picking and day trading to the professionals.

"Stick to the boring but effective strategy of saving early and often, watch investing fees, and picking an asset allocation plan where you can stay the course when the market inevitably takes a dive," says Ning.

And start as early as possible. According to personal finance expert Kimberly Palmer, someone who begins investing at age 25 will only have to save $4,830 annually to reach $1 million by age 65, accounting for an annual return of 7 percent after fees.

At some time (and for a lot of you, many times), life eventually will get in the way and you'll find yourself on the wrong side of your bank or, worse, a debt collector.

Stand your ground and watch them like a hawk. That means reading the fine print before signing up for a high-interest, high-fee credit card and taking a proactive approach to lower your interest rates on credit and mortgage loans. Sometimes, all it takes is a phone call and a little math work to figure out you could be getting a better deal elsewhere.

When in doubt, think about Kenny Golde, a 40-something producer we spoke with last year. He managed to negotiate $220,000 worth of debt down to $70,000 on his own.

And don't forget about the fees. Workers under age 59 1/2 who dip into retirement funds must generally pay back their loan quickly, between 30 to 90 days in most cases. Otherwise, you could wind up paying income taxes on whatever you've taken out, along with a 10 percent early withdrawal penalty. And you still have to pay back the loan with interest -- and with after-tax money, which then gets taxed again when you withdraw it in retirement.

We'll never tire of the Roth vs. Traditional 401(k) debate. With a Roth 401(k) or Roth IRA, all of your contributions are taxed immediately according to whatever tax bracket you fall into today. Traditional IRAs are tax-deferred until retirement.

The general consensus is that it's better to convert to or start a Roth now, since it's likely that you will wind up retiring in a higher tax bracket than you occupy now, in which case you'll pay significantly more in taxes later than you would today.

But investors who've already built a substantial IRA or 401(k) often can't stomach the thought of paying taxes on everything at once if they make the switch.

"Sometimes it just takes a lot of handholding because investors don't like to write that check," says Janet Briaud, chief investment officer of Briaud Financial Advisors. "There is sticker shock, but in the long-term, our clients really get it. They're really happy."

Ultimately, that money will be taxed one way or the other, either starting at age 70 1/2 when required minimum distributions take effect, or during the life expectancy of the beneficiaries, she argues. And if you leave a Roth IRA to your loved ones, you'll have the peace of mind of knowing they won't have to pay taxes on the money they withdraw.

To help ease the blow, speak with your advisor and try a partial conversion by moving just part of your savings to a Roth each year.

"Start by estimating your post-retirement expenses. Average it out across a year. From there, estimate what sort of investment returns you'll be able to generate -- yes, you'll need a crystal ball for this.

"From there, divide that rate (as a decimal) into one to find your multiplier. So, for example, if you think you can generate 4% real returns (i.e., 4% returns after accounts for inflation, so more like 7% nominal returns) then you'll need 25x your annual expenses (1 / 0.04 = 25). If you think you'll only be able to generate 3% real returns, then you'll need 33x your expenses. And so on."

The benefit of saving for your children's college education early (ideally via a 529 plan) is that you limit your saving burden by spreading it out over time.

But even if you come up short of tuition costs, don't immediately dip into you retirement savings to make up the difference.

"You can always fall back on financial aid. Grants, scholarships and student loans can help pay your child's way," writes Learnvest's Laura Shin. "When it comes to your retirement, however, there are no loans."

Of course, few people have the benefit of unlimited cash flow without putting in a little leg work first. But there are higher priorities in life than working overtime and depriving yourself of a few pleasures today just to save a buck or two.

"People spend most of their time planning their finances for old age, but not their fulfillment" along the way, says Ken Budd, executive editor of AARP The Magazine.

"We once profiled a man who decided that for the first year of retirement he would do whatever he wanted. So he went for long walks, he skimmed the newspaper online, he sat in Starbucks and read Grisham novels. But after that, he [felt so bored] he decided to become a chaplain."

Without a plan in place, you could leave your estate's future in the hands of squabbling family members or your state, which would appoint an administrator to handle everything.

"[A will] enables you to start thinking about issues like whether you have the right insurance coverage, life insurance, and ways of replacing your lost income," RocketLawyer founder Charley Moore says.

This is doubly important for gay spouses, as states that don't recognize gay marriages would pass over same-sex spouses in favor of next of kin.

I've had an ARM since purchasing my home in 1992. It has consistantly been lower than traditional mortgages. I never calculated how much money I saved over the years, but it must be substantial. But, as the article states, know exactly what's in your agreement. Make sure there is no prepayment penalty. I only have a small balance left on my mortgage, so if for some reason the rates would skyrocket, I'd simply pay it off.

Did a refi to am ARM in late 2009.....then got laid off (electrician). I was worried. I had planned on moving prior to the initial fixed rate expiring. Fortunatley, I did get back to work, and the interest rate has actually ticked down a couple of times.... so far so good.

Bigots love to blame the financial crisis on the CRA, but that is nonsense! Lenders inflated incomes to assure that the loans would be approved and sold the paper to financial institutions, that in turn bundled the loans and resold them to investors. Rating agencies gave the bundled loans investment quality ratings, joining in the fraud. Anyone who believes that the CRA is responsible is incapable of understanding the problem! Take a peek at “Inside Job,” or “Frontline-The Untouchables.”

We cannot trust the bush era policies. He and the GOP tried to ruin this country. Did we learn our lesson? If you are drawing a social security check and on medicare thank a democrat, if you want to end these two programs vote republican.

The big question is why did the interest rates suddenly almost double? nothing changed. Are they expecting millions of people to apply for ARMS? Or is this in anticipating 33 million visas being issued and they will all want homes? Or the illegals have enough money to buy homes ?

Anticipation of Gov to cut back on stimulus (buying $90B of bonds/month). That is why all the long term bond yields have increased so sharply in the last 2 months and long term mort rates follow the long term bonds and hence the short term ARM's not moving up much. It appears this trend will continue, but the rate of increase should slow now.

But it can reverse overnight if enough bad news comes out that should make wall street think that our economy will be going backwards again. And, of course, if investors start to feel the stock market is too high and start moving $$ into bonds, and that will drive the yields (and mort rates) down some, but not a whole lot.

Simple supply and demand. New housing is up (nearly 23% in my area over the last 2 years). Currently just in my township there are 73 new homes being built, 3 new developments being built with more than 155 singles and townhomes recently receiving township approval. The value of existing homes has risen 14% in the past 2 years. Interest rates have been held artificially low by the Fed. to induce home purchases. Obviously the time is coming where we're back to normal in the housing industry. My niece who is a realtor said business hasn't been this good since the collapse. She's making good money again. Unemployment has fallen to about 7.2% in my area. Construction is booming. Everywhere you look roads are being repaired/built, homes are being built, bridges are being repaired, etc.

Now we know why the housing industry is starting to make some movement upward. And guess what little ones...it's happening at a calculated timing rate to show how well the economy has progressed by the next general election. Very smart on someone's part (smile, wink, wink, nudge, nudge.)

Have to agree with most the negative comments, but an ARM does work very well and can save money if used correctly in the situations where it makes sense . However, it should NOT be used as the instrument to get an applicant.qualified In fact, I feel you should have to be able to meet the qualifications of a 15Y to get an ARM. I have couple ARM's on a couple of my rentals, but there is 35% equity in the places, and they will be paid off in full in 3-4 years, so it made sense to go that way. But most ARM's should NOT be granted, they are used incorrectly by people that do not know how to use them.